Transitioning From Growth To Retirement As A Real Estate Investor — End Game

Tonight we’ll take a look at how the ‘Millers’ real estate investors who Planned well, adapted to the inevitable downturns/corrections, and pulled the trigger with solid timing during the fun times. It’s a fiction perpetuated by the ever infamous ‘they’, that says any real estate investor will end up at retirement without a couple problems to solve, as long as they planned. B-o-l-o-n-e-y. I receive emails consistently from folks who’ve reached retirement only to realize there are a few irritating realities with which they must deal — which they should, and head on.

Our investor, I’m calling them the Millers, have been buying/selling/exchanging income property since 1976. Their first investment was a modest duplex in a blue collar section of town. They were immediately spoiled, if not misled by their initial experiences back then, as the market was in it’s first climb via double digit annual appreciation rates. As they began to believe in their ‘natural born wisdom’, October of 1979 hit, and well, it dawned on them they might not have been descendants of Midas after all.

They survived by merely holding on longer than anticipated, ’till things began to thaw in 1984. They regained their confidence by the end of 1985, exchanging up to more property, while making use of as much leverage as was prudent. They executed yet another 1031, en masse, in 1988 — taking full advantage of the second rising tide in just over a decade.

Shortly thereafter the S & L Crisis hit, and yet another holding period was extended, this time for longer than before. They didn’t make a move until the second half of 1996. I won’t go on with every move they made, but bottom line, as they entered 2009, their net equity had reached a number in excess of $3 Million — exclusive of their home and non-real estate assets.

Through changes in the Internal Revenue Code, and the implementation of their Purposeful Plan, they now have an impressive array of options on their transitional menu. They’re now 58 years old, in excellent health, and ready to proactively make the transition from capital growth to retirement income.

The Millers now own 23 smallish income properties, all producing various levels of cash flow, but not nearly what they have in mind. Of course, cash flow hasn’t been their objective up ’till now, as capital growth has been their focus from Day 1. If they’re able to secure a modest 6% yield on their current net equity, it would result in roughly $180,000 annual income. However, they say the first 10 years, a $100,000 yearly income will be just fine. They’d like to have the remainder of their equity channeled into income which would be scheduled to come online about 10 years after they retire. Obviously, regardless of the source of any retirement income, they’d like to have as much of it tax sheltered and/or tax free for as long as possible.

Here’s what they now Plan to do.

‘Cuz they have a boatload of unused depreciation available to offset capital gains taxes, they will pull much of it off the shelf to free about $1 Million to acquire a series of EIUL’s. (An EIUL — Equity Indexed Universal Life — is a fancy name for investment grade insurance. Over time it generates tax free income. This blog has several posts on the subject.) This will be done through an expert in that field, brought in well in advance, so as to blend well with the rest of the Plan’s chronology. Again, doing things on Purpose. For the record, it’s also no accident they had all that unused depreciation on the shelf in the first place.

The remainder of their holdings will be separated into two categories. One designated for sale or trade into cash flow properties, the other into either liquidation or hold. The latter category became necessary due to the current market correction. They acquired a few very small properties which are now worth much less than the original purchase price. This happens to everyone at one time or another (me included). As they execute this transition to retirement mode, they’ll sell the ones producing little or no income and with enough equity to pay costs. The ones without sufficient equity will simply remain on the back burner until ready to throw overboard, so to speak. Any losses incurred will be used to offset any capital gains taken via sale and not deferred via tax deferred exchange.

As we all know, it’s what we have in our Levi’s after April 15th that matters a wit. Tax shelter is the factor typically left out in the cold when retirement plans are made. This is a terrible mistake, as most tax deductions have disappeared by the time retirement beckons. Don’t blow this off, as it’s a huge deal.

Depending upon your personal biases and comfort level, the vehicles to which you move your equities will differ from investor to investor. For instance, some folks swear by triple net leased retail buildings. Almost no management to speak of — tenants pay for almost all operating expenses — and the leases are almost always 15-30 years in length. Personally, I think they’re overrated. If we’ve learned anything from our current economic reality, it’s that there are simply no ‘slam dunks’ or no-brainers out there. As I’ve shouted from the mountaintops here ad nauseam, you need to run from anyone claiming any investment is a ‘Can’t lose proposition’. I’ll not mince words here — anyone who says that either they’re stupid, or they think you are. Proceeding with the mindset you can’t lose is the first ingredient for disaster.

Due to the aging of Boomers, NNN leases with companies like Walgreen’s would likely be a rare exception to my stance here. They sell what seniors must have on a regular basis, and love to sign very long term leases yielding relatively reliable income. You need to have a seriously impressive collection of dead presidents though to make that happen.

4-5 star mobile home parks are also a demographic darling as many retirees find their post career finances, so finite in nature, a perfect fit for ‘Senior’ oriented parks. Folks generally own their own ‘homes’, and often their own lots. They tend to stick around ’till they pass on — and there’s almost always a waiting list for new openings. If you’re a semi-major player, that option might be a solid pick.

I prefer however, to spread the income out. Since their yield requirement in dollar terms translates into a conservative 5% yield — $100,000 income from $2 Million for immediate retirement income — a string of small residential income properties kills a few birds with one stone.

In today’s market, obtaining the goal of $100,000 a year using 2/3 of their net equity is immanently doable. In fact, they should be able to acquire slightly more than their $100,000 goal for annual income, targeted for the first decade of retirement. 25% of these properties will be acquired without the baggage of ‘adjusted basis’ attached to 1031 exchanges, as they will have used the remainder of their unused depreciation to make this possible. (A concept also explained in several different posts here.) The depreciation on those properties alone will amount to roughly $50,000 annually, which will stretch well into a long and healthy retirement. That means half of the $100,000 income for the first decade of their retirement is already tax sheltered by definition. The remaining tax shelter, provided by existing properties left unsold, plus the increased depreciation acquired through the tax deferred portion of this transition, will cover roughly $30-40,000 of additional income from their new properties.

In short, 70-90% (possibly, but not likely, all) of their new cash flow will be sheltered for at least a couple decades, some of it for almost 30 years. Due to nothin’ but luck, they’ve found themselves retiring during a window of historically low interest, and the opportunity to acquire new/newer properties as they enter retirement. Furthermore, demographic shifts are in favor of investors wanting long term stability, as employment and employees tend to travel together, then camp out wherever they light. There are a few regions where this is happening in real time, right now. The Miller’s couldn’t ask for better timing.

The EIUL will be ready to yield tax free income — for life — pretty much any time after the end of the 10th year. At that point it’s probably safe to say waiting the extra decade will be well worth it. I estimate the additional income by that point should be in the range of $80-110,000 a year, possibly more. Remember now, that’s tax free — for life. Upon the Millers’ passing, the cash value of the EIUL, will not be included in their estate. We all know what that means, right? NO taxes — it passes tax free to their kids. A good thing, as their 401k’s will be taxed into oblivion upon their death. Fortunately for them, they stopped funding their 401′s long ago, so the impact of that naked income, plus the inheritance tax won’t have nearly the impact it will have on most folks. A sad fact is, most folks have no idea how much the income from their 401k’s will be taxed while alive, and nearly slashed in half by taxes after their death.

A quick review shows the Millers retiring on $100,000+ a year for the first 10 years, the vast majority of which is safely tax sheltered. Though they can choose to begin taking the EIUL income any time after that first decade, every year it’s allowed to percolate increases the annual income they’ll be receiving tax free for life. Meanwhile, it’s a huge financial backstop, as they can borrow from the cash value at any time without the need to pay it back. No penalty, no tax, no interest, no nothing. Just take what they need. But it should absolutely be accessed only in a time of dire financial emergency. Nice to have though, eh?

From the time they hit 68 or so their retirement income, exclusive of Social Security (giggle) and 401k income (naked), will be a minimum of $180-200,000 — of which roughly 80%, give or take will either be tax sheltered or tax free. I’d say the Millers have done pretty well for themselves.

If you need to get going, or overhaul what you’ve been doing, give me a holler at 619 889-7100 or send me a message via the Contact BawldGuy button. Don’t wanna alarm anyone, but tick tock, ya know? Have a good one.

4 thoughts on “Transitioning From Growth To Retirement As A Real Estate Investor — End Game

  1. Another Investor

    Very interesting, but I see some questions that could significantly affect the scenario.

    1. It looks like they will be selling a mix of properties, including some they have held for a long time. How much depreciation recapture will there be on the properties that are sold without exchanges and do they have any way to shelter that “income” from taxes?

    2. With so many properties even after the portfolio is pruned, are they restricted to portfolio loans? What is the penalty in costs and rate if they are and what are the limits/ratios likely to be applied? In other words, how will the loan options available to them affect their purchases and exchanges?

    3. It sounds like the Millers have not yet retired and can therefore rely on their earned income to help them qualify for financing. How would the scenario change if there was a job loss or early retirement that reduced or eliminated their earned income?

    4. Over the two decade holding period, the income is likely to grow to the point the existing shelter is not big enough. Will these folks continue to move up over their retirement?

    I completely agree with you about the triple net leased retailers. In my 25 plus years of experience, I have seen plenty of empty big boxes formerly occupied by what were considered class A tenants. In fact, if you see a major retailer trying to do a sale-leaseback of all their owned stores on Loopnet, you can be pretty sure that company needs to raise capital. K-Mart did that not long before they went under.

    I’m even a little leery of Walgreens. There are plenty of vacant Walgreens and CVS stores in places that are overbuilt with retail centers. The typical Walgreens lease the last time I read one had a shorter initial term of 10 to 15 years (used to be 20 plus years) with a bunch of 5 year options. If you buy a 5 year old Walgreens with a 10 year initial term and the store goes dark, you could end up with a vacant store in a second class location in 5 years. I would research the area, the demographics, and the current and potential competition before I plunked down a dime of my money.

    I like your idea of a collection of smaller properties. There are times when diversification can protect you, and this is one of them.


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